Stocks: Trading on Margin

You can buy just about anything without paying the entire amount up front. Stocks are no different, thanks to buying on margin.

When you buy a stock on margin, you pay for a portion and leverage, or borrow, the rest (up to 50% on an initial investment) from your broker. The upshot on leveraging: When the stock goes up, you make a far greater profit on your initial investment. But when the stock goes down, you may end up owing more than your upfront investment.

Here's how it works: Let's say you want to buy 100 shares in XYZ Co.'s stock at $100. When you buy on margin, you pay $5,000 and your broker lends you the other $5,000. XYZ's stock rises 50% to $150, putting your total investment at $15,000, and you decide to sell. You pay your broker the $5,000 you owe, and you keep the other $10,000 (before commissions and interest paid to the broker).

What if the stock falls 50%? This is where the big risks of buying on margin arrive in the form of a margin call. If the value of your investment falls below 75% of its original value, your broker will issue a margin call, meaning you have to put more money into your margin account. If you can't put more money in, you have to sell the stock and pay the broker back the $5,000. If the stock fell 50% from $100 to $50, your investment is now worth $5,000. That money goes to the broker (plus commissions and interest you owe), and your initial $5,000 is gone.

The Federal Reserve, in part due to concerns about the larger implications of margin buying during a market downturn, has set standards on how much investors can buy on margin. The minimum initial margin requirement is 50%. But to maintain a margin account, the minimum can fall to as low as 25% (some firms require a higher percentage). Brokers may set their own levels for margin calls, but they can't be lower than 75%.

How to Use Margin

When you buy stocks on margin, you're opening up the possibility for far greater upside, or downside. Even if you decide not to use leverage to buy stocks, margin buying affects all investors because of its impact on the market. During the post-2000 market swoon, investor selling to meet margin calls was cited as a key factor that added to the downward pressure on stocks. To better understand what's a stake, check out these timeless articles from the experts at TheStreet.com.

Jim Griffin's Margin Cuts Both Ways

James Cramer's Using Margins Judiciously

James Cramer's More About Margin